Keeping Your Balance: Maximizing the tax benefits of the Domestic Production Activities Deduction

Listen to this article

Of course everyone wants to pay less in taxes, and in 2004 Congress gave manufacturing companies a huge tax break through the Section 199 Deduction, or as it is more commonly known, the Domestic Production Activities Deduction, or simply DPAD.

While this deduction involves a highly complex set of rules and regulations, in basic form, the deduction is 9% of the company’s net income from manufacturing, producing, growing or extracting activities performed in the United States.

For most taxpayers, this translates into a 3% tax rate reduction. This is a great benefit for manufacturing companies, but it didn’t stop there. Companies involved in the construction of real property, or in the engineering or architectural services can also qualify, as can the production of electricity, gas, water and films.

The deduction is limited to 50% of the company’s W-2 wages attributable to this income.

When Congress enacted this law, they did not specifically define what constitutes “manufacturing” activities. The IRS regulations state that in order to qualify as manufacturing, a material must have been subjected to processing, manipulating, refining, or otherwise changing its form, or by combining or assembling two or more articles.

The IRS regulations state that qualifying activities can consist of: Tangible personal property or any computer software; sound recordings or film; developing or improving; manufacturing  from raw material, or scrap or junk material; processing or refining; Combining, assembling or otherwise changing the form of the property; cultivating soil; raising livestock; and various other activities.

As you would expect, while the regulations attempt to cover most potential qualifying activities, taxpayers push the boundaries of the law in an effort to maximize the deduction and pay less tax. This has resulted in a significant increase in IRS regulations to prevent abuse, and a corresponding increase in the number of court cases surrounding this deduction. Lately, the Courts and the IRS have differed over a key distinction in the rules regarding how much work needs to be done to change a product in order to qualify as manufacturing.

In a recent Court case, an S corporation filed amended tax returns in order to claim the DPAD. The Company produced gift baskets, starting with empty baskets (purchased overseas) and filed them with food items and various packing and other materials. The company used an assembly line process where employees filled the baskets with food and other items. Similarly, the company also prepared “gift towers” of items in stacked sets of decorative boxes. Both the baskets and towers underwent additional decorating and wrapping.

The IRS challenged this position, claiming that gift baskets and towers were simply repackaged items, not manufactured. The taxpayers asserted that the gift baskets and towers were manufactured and/or produced within the meaning of the regulations. They argued that the Company had changed the form of the product by specifically selecting the items, then creating and assembling the gift baskets and towers. Though any of the items could be bought at a store, the taxpayers claimed that their rearrangements created a collection that was different from the individual items, thereby changing its overall form.

The Court held that the Company did indeed change the form and function of the individual items through its production process. Countering the IRS assertion that the Company’s activity was more closely resembling that of a car being customized (which under the regulations is not a qualifying activity), the court held that the process was more attuned to manufacturing a car by assembling parts from various suppliers. The Court concluded that customizing a car does not change its nature, while combining various items into a gift basket creates a new product with a different demand than that each individual item.

Understandably, the IRS did not agree with Court in this case, and therefore proposed new regulations in August 2015. These new regulations included a new example of non-qualifying packaging, repackaging, labeling, or minor assembly, in order to address and counter the Court’s holding. The proposed regulations specifically identified a business which sells gift baskets containing various products packaged together. In the IRS’ example, a business purchases baskets and their contents from third parties, arranged the products in the baskets, sometimes relabeling the items, and used an assembly line to put the baskets together. The business performed no other activity besides packaging, repackaging, labeling, or minor assembly. Thus, the proposed example states the business did not engage in a qualifying activity and therefore is not eligible to claim the DPAD.

Just a few days after the IRS issued these new proposed regulations, another District Court came to the rescue of taxpayers in a similar situation. In this case, the company purchased drugs in bulk, and repackaged the medications in non-reusable single dose units for sale to various medical facilities.

The Court determined that the single use doses could come into existence only due to the Company’s process, even though the Company did not create the containers or the medications. The Court stated this situation was similar the first case noted above. The Court noted that the company performed repackaging, but they also performed other production activities such as market research, mixing studies, design, and testing, all of which created a “complex production process that results in a distinct final product”

How this might impact your business?

At this point in time, it would appear that the IRS would continue to challenge businesses that deducted DPAD where they believed that the business process was mere assembly with no significant change to the final product. The IRS has not withdrawn the proposed regulation nor the examples. If a business can show that their process results in a distinct final product, especially where the packaging, assembly, and relabeling were part of a more complex process, they should be able to survive an IRS challenge, even if it might mean going to court.

If there is doubt as to whether a business or segment of the business may qualify under the recent court findings, it would be beneficial to have a tax professional review the situation and help prepare an analysis of the benefits and potential costs of defending an IRS challenge relating to claiming the DPAD. The Company should establish and document in detail how the business process is an activity that goes beyond just minor repackaging or minor assembly, and demonstrate how the process creates a “new product”

Burton S. Speer is a partner in the tax department at Mengel, Metzger, Barr & Co. LLP and can be reached at [email protected] or 585-423-1860.